RIA Compliance Blog
The SEC has filed fraud charges against a large ($85 billion AUM) registered investment adviser for its failure to disclose material conflicts of interest in connection with a “revenue sharing” arrangement with its clearing broker. The SEC’s Complaint against the adviser, Boston-based Commonwealth Equity Services, LLC, d/b/a Commonwealth Financial Network (“Commonwealth”), was filed in Massachusetts federal district court, and alleges that Commonwealth received over $100 million in revenue sharing from the clearing broker while failing to properly apprise its advisory clients of the full nature of the revenue sharing arrangement and the inherent conflicts of interest implicated by it. The Commonwealth case is just the latest in a string of actions by the SEC involving mutual fund share class selection by advisers and comes on the heels of the recent DC Circuit decision in the Robare case, which has likely emboldened the SEC somewhat.
The Commonwealth case involves a revenue sharing arrangement between Commonwealth and National Financial Services, LLC (“NFS”), an affiliate of mutual fund giant Fidelity Investments. Pursuant to that arrangement, NFS paid Commonwealth a percentage of the money paid to NFS by mutual fund companies in return for the right to sell their mutual funds through NFS. The money paid to Commonwealth by NFS under this arrangement, in turn, was directly related to the amount of Commonwealth client assets invested in certain share classes of specific funds offered on NFS’ platform. In other words, the more client assets placed by Commonwealth into particular funds and classes of those funds, the more revenue shared with Commonwealth.
As the SEC notes in its Complaint, there are obvious and significant conflicts of interest inherent in a fee sharing program of this type. Simply put, Commonwealth had a huge financial incentive to invest its clients’ money into those mutual funds that would pay the most shared revenue to Commonwealth. However, the very existence of such conflicts is not necessarily fatal. Rather, when engaging in conflicted activity such as the case here, an adviser must supply its clients with full and fair disclosure of all material facts surrounding the conflict so as to enable the client to provide the adviser with an informed consent to the conflict (or alternatively, to walk away from the conflicted transaction). Indeed, as we have discussed in detail in our most recent post on this blog, this duty to provide full and fair disclosure sufficient enough to enable informed consent by the client is the very cornerstone of an adviser’s fiduciary duty to its clients. Clearly, here the SEC is of the opinion that Commonwealth breached that fiduciary duty on a number of fronts.
Specifically, the SEC contends that Commonwealth failed to tell its clients all of the following: (i) that, in certain cases, it received revenue sharing payments from NFS at all; (ii) that it had strong financial incentives, in the form of revenue sharing payments from NFS, to place its clients’ money into more costly mutual funds, including more costly share classes while more inexpensive share classes were available for the same exact fund; and (iii) that there were in fact mutual funds available to its clients for which NFS did not pay revenue sharing to Commonwealth. Accordingly, the SEC argues that “Commonwealth’s advisory clients invested without a full understanding of the firm’s compensation motives and incentives.” The SEC seeks a permanent injunction, disgorgement, and an appropriate civil penalty from the court.
Parker MacIntyre provides legal and compliance services to investment advisers, broker-dealers, registered representatives, hedge funds, and issuers of securities, among others. Our Investment Adviser Group assists financial service providers with complex issues that arise in the course of their business, including complying with federal and state laws and rules. Please visit our Investment Adviser Practice Group page for more information.